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Produce More Investment Income and Protect Against Rising Rates


Rising interest rates would cause the value of long- and intermediate-term bond funds to plummet. Since these funds are too risky today, what's the best way to get decent income today?

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Rising interest rates would cause the value of long- and intermediate-term bond funds to plummet. Since these funds are too risky today, what’s the best way to get decent income today?

With most of your fixed-income portfolio: KISS (Keep It Short and Simple).

Put at least 60% in short-term certificates of deposits, money market funds, and high-quality short-term bond funds with an average maturity of about two years or less. (If your tax bracket is high enough, use short-term tax-free funds.)

But also invest in alternatives to basic short-term funds. They generally pay higher yields and are well positioned to keep their value when rates rise, which is bound to happen in the near future.

Non-Vanilla Funds Boost Income, Buffer Rate Hikes

If you can take just a bit more risk, invest up to 40% of your fixed-income portfolio in non-vanilla income funds. That allocation can be split among three buckets.

Merger arbitrage funds. Up to 10% can go into a merger-arbitrage mutual fund, a specialized type of stock fund with nearly bond-like performance. The fund buys shares of merger acquisition targets at a slight discount to the expected value upon completion of the deal. This price difference is known as the arbitrage spread and is captured as long as the deal is completed. The manager buys protection in case the deal falls through.

It’s a concept with a solid long-term record.

Inflation-managed bond funds. Consider investing 10-15% in them. These hybrid funds include inflation swaps along with short-term fixed-income holdings. An inflation swap involves one party paying a fixed rate on the swap amount in exchange for a floating-rate payment based on actual inflation.

These funds are an effective way to mitigate the effects of inflation while keeping interest-rate risk low.

Floating-rate bond funds—also known as bank-loan funds. Another 10-15% out of the 40% can go into them. These funds purchase loans made by banks to companies with below-investment-grade credit ratings. The underlying loans’ yields float, generally rising with broader market rates, protecting investors from most interest-rate risk.

Unlike high-yield junk bonds (which are generally too risky), floating-rate loans have safeguards built in, including collateral, performance-based covenants and a senior debt position. Senior debt is more likely than other debt to be repaid in case of a bankruptcy.

Look for a conservatively managed floating-rate fund instead of trying to find the highest yield.

There is no one-size-fits-all strategy for fixed-income investing. The techniques described here are not the only options, and any plan should be tailored to an individual portfolio based on your risk tolerance, liquidity needs, investment horizon and personal goals.

But there is one universal truth.

Fixed-income investments should be conservative, used for reducing volatility of the total portfolio and preserving wealth, not risking it.

Thomas Walsh is an investment analyst in Palisades Hudson Financial Group’s Atlanta office.

Palisades Hudson is a fee-only financial planning firm and investment adviser based in Scarsdale, NY, with $1.3 billion under management. It offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family-office and business management, tax preparation and executive financial planning. Branch offices are in Atlanta, Fort Lauderdale, FL, and Portland, OR.

The firm’s recent book, Looking Ahead: Life, Family, Wealth and Business After 55, is a paperback and Kindle e-book available on Amazon at http://tinyurl.com/ocro2dx and at Barnes & Noble at http://tinyurl.com/m9ca3qk. Read Palisades Hudson’s daily column on personal finance, economics, and other topics at http://palisadeshudson.com/current-commentary. Twitter: @palisadeshudson.

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